Correlations, Value Factor Returns and Growth Options

Abstract

This paper documents that the average equity market correlation is informative about the value of growth options and the correlation dynamics of growth and value stocks and, in turn, forecasts changes in growth options and the returns on the value factor. Consistently, a production-based asset-pricing model shows that correlations are homogeneous among stocks with similar growth characteristics and increasing in the value of growth options. Therefore, the expected average equity correlation serves as a leading procyclical state variable and drives the value premium. Correlations extracted from an equity value index improve the predictability of value-related factors in-sample and out-of-sample.

Keywords: option-implied correlations, value premium, present value of growth options, production model, factor return predictability, option-implied information, trading strategy, diversification, factor risk